A Check-List

 

Checklist for Buying Good Companies at Reasonable Prices

Here is a summary of the questions an investor should ask for investing in good companies at fair prices.


Questions 1 - 19:  Focus on the areas of the business.

Business Nature
1.  Do I understand the business?
2.  What is the economic moat that protects the company so it can sell the same or a similar product five or ten years from today?
3.  Is this a fast-changing industry?
4.  Does the company have a diversified customer base?
5.  Is this an asset-light business?
6.  Is it a cyclical business?
7.  Does the company still have room to grow?

Business Performance
8.  Has the company been consistently profitable over the past ten years, through good times and bad?
9.  Does the company have a stable double-digit operating margin?
10. Does the company have a higher margin than competitors?
11. Does the company have a return on investment capital of 15% or higher over the past decade?
12. Has the company been consistently growing its revenue and earnings at double digits?

Business Financial Strength
13. Does the company have a strong balance sheet?

Business Management
14. Do company executives own decent shares of stock of the company?
15. How are the executives paid compared with other similarly sized companies?
16. Are insiders buying?

Business Valuation
17. Is the stock valuation reasonable as measured by intrinsic value, or P/E ratio?
18. How is the current valuation relative to historical range?
19. How did the company's stock price fare during the previous recessions?


Question 20:  Confidence in Your Business Analysis or Research

20. How much confidence do I have in my research?




The final question centers on how you feel about your research.  Though it is not directly related to the company, your own analysis is a vital consideration.  It determines your action once the stock suddenly drops 50% after you buy.

That same 50% drop can trigger opposing actions depending on your level of confidence.

• If you are assured in your research, the 50% drop in price is a great opportunity to buy more of the stock at half the price.  
• If you don't have confidence, you will likely be scared into selling at a 50% loss.

It will happen after you buy the stock and, paradoxically, it happens only after you buy.  So, get prepared!


The checkup questions are based on the company's financial data.  None of them should replace your work of understanding the business and learning about its products, its customers, its suppliers, its competitors, and the people who work in the company.  The warning signs serve as reminders of where you are.  They are not meant to substitute for understanding.  If we paid attention only to the numbers and signs and ignore the business itself, understanding of the company business is incomplete.

If we gain a solid understanding of the business, these numbers and signs will help us to appreciate where we are and where we are probably going.  If business understanding is qualitative and the numbers are quantitative, both are needed to gain the confidence we need for our research.

The checklist is a useful tool for investors to maintain discipline in their stock picking.

Stock Valuation Manifesto Checklist

September 11, 2017 | Vishal Khandelwal  

https://www.safalniveshak.com/stock-valuation-manifesto/

I had released my Investor’s Manifesto couple of years back. Now, here is my fifteen-point stock valuation manifesto that I penned down a few months back though I have been using it as part of my investment process for a few years now.

It is evolving but is something I reflect back on if I ever feel stuck in my stock valuation process. You may modify it to suit your own process and requirements. But this in itself should keep you safe.

Read it. Print it. Face it. Remember it. Practice it.

[Your Name]’s Stock Valuation Manifesto

1. I must remember that all valuation is biased. I will reach the valuation stage after analyzing a company for a few days or weeks, and by that time I’ll already be in love with my idea. Plus, I wouldn’t want my research effort go waste (commitment and consistency). So, I will start justifying valuation numbers.
2. I must remember that no valuation is dependable because all valuation is wrong, especially when it is precise (like target price of Rs 1001 or Rs 857). In fact, precision is the last thing I must look at in valuation. It must be an approximate number, though based on facts and analysis.
3. I must know that any valuation method that goes beyond simple arithmetic can be safely avoided. If I need more than four or five variables or calculations, I must avoid that valuation method.
4. I must use multiple valuation methods (like DCF, Dhandho IV, exit multiples) and then arrive at a broad range of values. Using just a single number or method to identify whether a stock is cheap or expensive is too much oversimplification. So, while simplicity is a good habit, oversimplifying everything may not be so.
5. If I am trying to seek help from spreadsheet based valuation models to tell me whether I should buy, hold, sell, or avoid stocks, I am doing it wrong. Valuation is important, but more important is my understanding of the business and the quality of management. Also, valuation – high or low – should scream at me. So, I may use spreadsheets but keep the process and my underlying thoughts simple.
6. I must remember that value is different from price. And the price can remain above or below value for a long time. In fact, an overvalued (expensive) stock can become more overvalued, and an undervalued (cheap) stock can become more undervalued over time. It seems harsh, but I cannot expect to fight that.
7. I must not take someone else’s valuation number at face value. Instead, I must make my own judgment. After all, two equally well-informed evaluators might make judgments that are wide apart.
8. I must know that methods like P/E (price to earnings) or P/B (price to book value) cannot be used to calculate a business’ intrinsic value. These can only tell me how much a business’ earnings or book value are priced at vis-à-vis another related business. These also show me a static picture or temperature of the stock at a point in time, not how the business’ value has emerged over time and where it might go in the future.
9. I must know that how much ever I understand a business and its future, I will be wrong in my valuation – business, after all, is a motion picture with a lot of thrill and suspense and characters I may not know much about. Only in accepting that I’ll be wrong, I’ll be at peace and more sensible while valuing stuff.
10. I must remember that good quality businesses often don’t stay at good value for a long time, especially when I don’t already own them. I must prepare in advance to identify such businesses (by maintaining a watchlist) and buy them when I see them priced at or near fair values without bothering whether the value will become fairer (often, they do).
11. I must remember that good quality businesses sometimes stay priced at or near fair value after I’ve already bought them, and sometimes for an extended period of time. In such times, it’s important for me to remain focused on the underlying business value than the stock price. If the value keeps rising, I must be patient with the price even if I need to wait for a few years (yes, years!).
12. Knowing that my valuation will be biased and wrong should not lead me to a refusal to value a business at all. Instead, here’s what I may do to increase the probability of getting my valuation reasonably (not perfectly) right –
    
    
    
    • I must stay within my circle of competence and study businesses I understand. I must simply exclude everything that I cannot understand in 30 minutes.
    • I must write down my initial view on the business – what I like and not like about it – even before I start my analysis. This should help me in dealing with the “I love this company” bias.
    • I must run my analysis through my investment checklist. I have seen that a checklist saves life…during surgery and in investing.
    • I must, at all cost, avoid analysis paralysis. If I am looking for a lot of reasons to support my argument for the company, I am anyways suffering from the bias mentioned above.
    • I must use the most important concept in value investing – margin of safety, the concept of buying something worth Rs 100 for much less than Rs 100. Without this, any valuation calculation I perform will be useless. In fact, the most important way to accept that I will be wrong in my valuation is by applying a margin of safety.
13. Ultimately, it’s not how sophisticated I am in my valuation model, but how well I know the business and how well I can assess its competitive advantage. If I wish to be sensible in my investing, I must know that most things cannot be modeled mathematically but has more to do with my own experience in understating businesses.
14. When it comes to bad businesses, I must know that it is a bad investment however attractive the valuation may seem. I love how Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”
15. I must get going on valuing good businesses…but when I find that the business is bad, I must exercise my options. Not a call or a put option, but a “No” option. 

https://www.safalniveshak.com/stock-valuation-manifesto/

How to find Quality Companies? (Checklist)

Here is a useful checklist you can use when you are searching for quality companies:

1.   Company's sales record.

• You want to see high and growing sales, year after year.
• A ten-year period of increasing sales and profits is a good sign.

2.  Company's profits.

• You want to see high and growing profits, as measured by normalised EBIT, year after year.
• A ten-year period of increasing sales and profits is a good sign.

3. EBIT and normalised EBIT 

• Check that these are roughly the same in most of the last ten years.

4.  EBIT margin.  

• The EBIT margin must be of at least 10% almost every year for the last ten years.

5,  ROCE

• The company must have a ROCE that is consistently above 15% over the last ten years.
• ROCE = (EBIT / average capital employed ) x 100%

6.  DuPont analysis

• Carry out a DuPont analysis to find out what is driving a company's ROCE.
• ROCE = EBIT/Capital Employed = (EBIT/Sales) x (Sales/Capital Employed)
• ROCE = {Profit margin x Capital turnover)

7.  Annual report

• Read a company's annual report to provide context for the numbers.

8.  FCFF and FCF

• Look for a growing free cash flow to the firm (FCFF) and free cash flow for shareholders (FCF), over a period of ten years.
• FCFF and FCF should also be roughly the same in most years.
• That is, little debt.

9.  Operating cash conversion ratio 

• Look for companies that turn all of their operating profits (EBIT) into operating cash flow, as represented by an operating cash conversion ratio of 100% or higher.
• Operating cash conversion ratio = (operating cash flow / operating profit) x 100%
• That is, high quality earnings

10.  Capex ratio

• Look for capex ratio less than 30% almost every year over the last ten years.
• That is, low capex requirements.
• Capex ratio = Capex / Operating Cash Fow

11.  Compare Capex to its depreciation and amortisation expenses.

• If the company is spending more on capex than its depreciation and amortisation expenses, it is a sign that it is spending enough but you need to be sure it isn't spending too much.

12.  FCFF/Capital Employed or CROCI

• Check for free cash flow to firm return on capital invested that is higher than 10% almost every year over the last ten years.
• This is also known as cash-flow return on capital invested (CROCI)
• CROCI = adjusted free cash flow tot he firm (FCFF)/average capitl employed

13.  Compare FCFps to EPS

• Look for free cash flow per share to be close to earnings per share in most of the last ten years.
• That is, high quality earnings.

14.  Free cash flow dividend cover

• Free cash flow per share should be a larger number than dividend per share in most years.
• That is, the free cash flow dividend cover should be greater than 1.
• Free cash flow dividend cover = FCFps / DPS
• Occasional years when this is not the case are fine.

15.  Consistent Growth

• Prefer more consistent growth in turnover and profit to more volatile growth.

Comments:


Don't worry if you cannot find a company that meets ALL of the criteria above.

There are some exceptional companies that do.

Typically you will not find hundreds of them.

Companies can improve and the ones that might not have been good ten years ago can be good companies now.

If you can find companies that have a high and improving ROCE and have been good at converting profits into free cash flow over the last five years, you should consider them as well.

How to value shares (checklist)

Here is a checklist to remind me of the process when valuing shares:

1.  Value the companies using an estimate of their cash profits.

• What is the cash yield a company is offering at the current share price?
• Is it high enough?

2.  Calculate the company's earnings power value (EPV).

• How much of a company's share price is explained by its current profits?
• How much is dependent on future profits growth? 
• If more than half of the current share price is dependent on future profits growth, do not buy these shares.

3.  What is the maximum price you will pay for a share.

• You should try and buy shares for less than this value.  
• Apply a discount of at least 15%.
• The interest rate applied to calculate the maximum price should be at least 3% more than the rate of inflation.

4.  To pay a price at or beyond the valuations above, you must be confident in the company's ability of continuing future profits growth (quality growth companies).

• The higher the price paid for profits/turnover/growth, the more risk you are taking with your investment.
• If profits stop growing, then paying an expensive price for a share can lead to substantial losses.

Additional notes:

Investing using checklists is a very powerful method.

It focuses your thinking and guides you in the investing process.

If you are to be a successful investor in shares, you need to pay particular attention to the price you for for them.

• The biggest risk you face is paying too much.
• It is important to remember that no matter how good a company is, its shares are not a buy at any price.

Paying the right price is just as important as finding a high quality and safe company.

• Overpaying for a share makes your investment less safe and exposes you to the risk of losing money.

Also, do not be too mean with the price you are prepared to pay for a share.

• Obviously you want to buy a share as cheaply as possible, but you should also realise that you usually have to pay up for quality.
• Waiting to buy quality shares for very cheap prices may mean that you end up missing out on some very good investments.
• Some shares can take years to become cheap and many never do.

My Check Lists

Here is a Ben Graham Checklist for Finding Undervalued Stocks

Criterias


Valuation
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.


Quality of Balance Sheet and Management
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.


Quality of Growth
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.


If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham

If you're income oriented, Graham recommended paying special attention to items 1 through 7.

If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.

If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.

Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.  

The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.  

Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html

If you're income oriented, Graham recommended paying special attention to items 1 through 7.

Quote

Criterias


Valuation
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.


Quality of Balance Sheet and Management
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.


Quality of Growth
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.

--------------------------

If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.

Quote

Criterias


Valuation
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.


Quality of Balance Sheet and Management
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.


Quality of Growth
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.

---------------------------

If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.

Quote

Criterias


Valuation
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.


Quality of Balance Sheet and Management
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.


Quality of Growth
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.

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To Sell or to Hold Checklist

To Sell or to Hold Checklist
http://www.bivio.com/crowriver/files/Webpages/To%20Sell%20or%20to%20Hold%20Checklist.pdf


Portfolio Management Workshop


PORTFOLIO MANAGEMENT

Portfolio Management essentially consists of the activities that help investors reach desired investment goals. It is the art of optimizing holdings and increasing the value of a portfolio. And it takes some common sense and diligence to do it successfully. At times, it even takes a little courage.

This workshop will discuss the process and the tools at your disposal to make the most of your investments. It may also suggest some answers to some of the questions you may have about when or why you should sell your stocks and what you might want to do in today's market.

Investor's Checklist: A Guided Tour of the Market

The list below covers just about every corner of the market.  It should help you wade through the different economics of each industry and understand how companies in each industry can create economic moats - which strategies work and how you can identify companies pursuing those strategies.

Over the long haul, a big part of successful investing is building a mental database of companies and industries on which you can draw as the need arises.  The list below should give you a jumpstart in compiling that mental database, and that will make you a better investor.

• Investor's Checklist: Health Care
• Investor's Checklist: Consumer Services
• Investor's Checklist: Business Services
• Investor's Checklist: Banks
• Investor's Checklist: Asset Management and Insurance
• Investor's Checklist: Technology Software
• Investor's Checklist: Technology Hardware
• Investor's Checklist: Media
• Investor's Checklist: Telecom
• Investor's Checklist: Consumer Goods
• Investor's Checklist: Industrial Materials
• Investor's Checklist: Energy
• Investor's Checklist: Utilities

It is easier for companies to make money in some industries than in others. Some industries lend themselves to the creation of economic moats more so than others, and these are the industries where you'll want to spend most of your time. The economics of some industries are superior to others. Hence, you should spend more time learning about attractive industries than unattractive ones. Every industry has its own unique dynamics and set of jargon - and some industries (such has financial services) even have financial statements that look very different.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey

Investor's Checklist: Health Care

Developing drugs is time-consuming, costly, and there are no guarantees of success.  Look for companies with long patent lives and full pipelines to spread the development risk.

Drug companies whose products target large patient populations or significant unmet needs have a better chance of paying off.

Make sure you have a big margin of safety for pharmaceutical companies with mega blockbuster drugs that make up a large percentage of sales.  Any unexpected development can send cash flow, and the stock price, reeling.

Unless you have a deep understanding of the technology, don't invest in biotech startups.  Payoffs could be large, but the cash flows are so far out and uncertain that it's easier to lose your shirt than win big.

Don't overlook the medical device industry, which is full of firms with wide economic moats.

Cash is king for firms that rely on development (pharmaceuticals, biotechnology, and medical devices).  Make sure firms have enough cash or cash from operations to get through the next development cycle.

Keep an eye on the government.  Any drastic changes in Medicare/Medicaid spending or regulatory requirements can have a deep impact on pricing throughout the sector.

Managed care organizations that spread risk - whether through a high mix of fee-based business, product diversification, strong underwriting, or minimal government accounts - will provide more sustainable returns.  

Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey


Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Consumer Services

Most consumer services concepts fail in the long run, so any investment in a company in the speculative or aggressive growth stage of the business life cycle needs to be monitored more closely than the average stock investment.

Beware of stocks that have already priced in lofty growth expectations.  You can make money if you get in early enough, but you can also lose your shirt on the stock's rapid downslide.

The sector is rife with low switching costs.  Companies that establish store loyalty or store dependence are very attractive.  Tiffany's is a good example; it faces limited competition in the retail jewelery market.

Make sure to compare inventory and payables turns to determine which retailers are superior operators.  Companies that know what their customers want and how to exploit their negotiating power are more likely to make solid bets in the sector.

Keep an eye on those off-balance sheet obligations.   Many retailers have little or no debt on the books, but their overall financial health might not be that good.

Look for a buying opportunity when a solid company releases poor monthly or quarterly sales numbers.  Many investors overreact to one month's worth of bad same-store sales results, and the reason might just be bad weather or an overly difficult comparison to the prior-year period.  Focus on the fundamentals of the business and not the emotion of the stock.

Companies also tend to move in tandem when news comes out about the economy.  Look for a chance to pick up shares of a great retailer when the entire sector falls - keep that watch list handy.  


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey


Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Business Services

Understand the business model.  Knowing if a company leverages technology, people, or hard assets will provide insight as to the kind of financial results the company may produce.

Look for scale and operating leverage.  These characteristics can provide significant barriers to entry and lead to impressive financial performance.

Look for recurring revenue.  Long-term customer contracts can guarantee certain levels of revenue for years into the future.  This can provide a degree of stability in financial results.


Focus on cash flow.  Investors ultimately earn returns based on a company's cash-generating ability.  Avoid investments that aren't expected to generate adequate cash flow.

Size the market opportunity.  Industries with big, untapped market opportunities provide an attractive environment for high growth.  In addition, companies chasing markets perceived to be big enough to accommodate growth for all industry participants are less likely to compete on price alone.

Examine growth expectations.  Understand what kind of growth rates are incorporated into the share price.  If the rates of growth are unrealistic, avoid the stock.  



Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Banks

The business model of banks can be summed up as the management of three types of risk:  credit, liquidity, and interest rate.

Investors should focus on conservatively run institutions.  They should seek out firms that hold large equity bases relative to competitors and provision conservatively for future loan losses

Different components of banks' income statements can show volatile swings depending on a number of factors such as the interest rate and credit environment.  However, well-run banks should generally show steady net income growth through varying environments.  Investors are well served to seek out firms with a good track record.

Well-run banks focus heavily on matching the duration of assets with the duration of liabilities.  For instance, banks should fund long-term loans with liabilities such as long-term debt or deposits, not short-term funding. Avoid lenders that don't.

Banks have numerous competitive advantages.  They can borrow money at rates lower than even the federal government.  There are large economies of scale in this business derived from having an established distribution network.  the capital-intensive nature of banking deters new competitors.  Customer-switching costs are high, and there are limited barriers to exit money-losing endeavors.

Investors should seek out banks with a strong equity base, consistently solid ROEs and ROAs, and an ability to grow revenues at a steady pace.


Comparing similar banks on a price-to-book measure can be a good way to make sure you're not overpaying for a bank stock.


Ref:  The Five Rules to Successful Stock Investing by Pat Dorsey


Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Asset Management and Insurance

Look for diversity in asset management companies.  Firms that manage a number of asset classes - such as stocks, bonds, and hedge funds - are more stable during market gyrations.  One-hit wonders are much more volatile and are subject to wild swings.

Keep an eye on asset growth.  Make sure an asset manager is successful in consistently bringing in inflows greater than outflows.

Look for money managers with attractive niche markets, such as tax-managed funds or international investing.

Sticky assets add stability.  Look for firms with a high percentage of stable assets, such as institutional money managers or fund firms who specialize in retirement savings.

Bigger is often better.  Firms with more assets, longer track records, and multiple asset classes have much more to offer finicky customers.

Be wary of any insurance firm that grows faster than the industry average (unless the growth can be explained by acquisitions).

One of the best ways to protect against investment risk in the life insurance world is to consider companies with diversified revenue bases.  Some products, such as variable annuities, have exhibited a good degree of cyclicality.

Look for life insurers with high credit ratings (AA) and a consistent ability to realise ROEs above their cost of capital.

Seek out property/casualty insurers who consistently achieve ROEs above 15 percent.  This is a good indication of underwriting discipline and cost control.

Avoid insurers who take repeated reserving charges.  This often indicates pricing below cost or deteriorating cost inflation.

Look for management teams committed to building shareholder value.  These teams often have significant personal wealth invested in the businesses they run.



Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey


Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Technology Software

The software industry has economics few industries can match.  Successful companies should have excellent growth prospects, expanding profit margins, and pristine financial health.

Companies with wide moats are more likely to produce above-average returns.  But superior technology is one of the least sustainable competitive advantages in the software industry.

Look for software companies that have maintained good economics throughout multiple business cycles.  We prefer companies that have been around at least several years.

License revenue is one of the best indicators of current demand because it represents how much new software was sold at a given time.  Watch for any license revenue trends.

Rising days sales outstanding (DSOs) may indicate a company has extended easier credit terms to customers to close deals.  This steals revenues from future quarters and may lead to revenue shortfalls.

If deferred revenue growth slows or the deferred revenue balance begins to decline, it may signal that the company's business has started to slow down.

The pace of change makes it tough to predict what software companies will look like in the future.  For this reason, it's best to look for a big discount to intrinsic value before buying.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Technology Hardware

Information technology is an increasingly important source of productivity in advanced economies.  In 2002, IT accounted for nearly 50 percent of total U.S. investment in capital equipment, up from 20 percent three decades ago.

Technology innovation means that hardware firms can offer more computing power at an increasingly cheap price; thus, IT can be applied to more and more task.


Because of rapid innovation, technology hardware companies tend to generate rapid revenue and earnings growth.

At the same time, competitive rivalry is often strong in tech hardware.  Moreover, demand for technology hardware is very cyclical.

Technology, by itself, does not constitute a sustainable competitive advantage.  hardware companies that develop economic moats are more likely to succeed over the long term than companies that rely on a lead in technology.

Examples of moats among technology hardware firms include low-cost producer (Dell), intangible assets (Linear and Maxim), switching costs (Nortel and Lucent), and network effect (Cisco).

A company with a sustainable competitive advantage should be able to effectively fend off its rivals and maintain significant market share and/or sustain above-average margins over an extended period of time.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Media

Look for media companies that consistently generate strong free cash flow.  We like to see free cash flow margins around 10 percent.

Seek out companies that have high market share in their primary markets - monopolies are often great for profits.  Licenses, especially in broadcasting, also serve to reduce competition and keep profit margins high.

Seek out companies with a history of well-executed acquisitions that have been followed by higher margins.

A strong balance sheet enables media companies to make selective acquisitions without increasing the risk for shareholders or diluting the shareholders' ownership stake.

Look for candid management teams, a history of sensible acquisitions, and either conservative reinvestment of shareholders' capital or the return of capital to shareholders through dividends and stock repurchases.


Don't chase hits.  Buying a stock because there's a lot of buzz about a hit movie or TV show rarely pays off.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



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Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Telecom

Shifting regulations and new technologies have made the telecom industry far more competitive.  Though some areas are more stable than others, look for a wide margin of safety to any estimate of value before investing.

Telecom is a capital-intensive business.  Having the resources to maintain and improve the network is critical to success.

Telecom is high fixed-cost business.  Keeping an eye on margins is very important.

Watching debt is also important.  Firms can easily overextend themselves as they build networks.


The price of wireless airtime is plummeting.  Carriers continue to compete primarily on price.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



Read also:
Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Consumer Goods

Find companies that enjoy the cost advantages of manufacturing on a larger scale than most other competitors.  One related issue is whether the firm holds dominant market share in its categories.

Look for the firms that consistently launch successful new products - all the better if the firm is first to market with these innovations.

Check to see if the company is supporting its brand with consistent advertising.  If the firm constantly promotes its products with sale prices, it's depleting brand equity and just milking the brand for shorter-term gain.

Examine how well the firm is handling operating costs.  Occasional restructuring can help squeeze out efficiency gains and lower costs, but if the firm is regularly incurring restructuring costs and relying solely on this cost-cutting tactic to boost its business, tread carefully.

Because these mature firms generate so much free cash flow, it's important to make sure management is using it wisely.  How much of the cash is turned over to shareholders in the form of dividends or share repurchase agreements?

Keep in mind that investors may bid up a consumer goods stock during economic downturns, making the shares pricey relative to its fair value.  Look for buying opportunities when shares trade with a 20 percent to 30 percent margin of safety.  

Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



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Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Industrial Materials

This is a very traditional Old Economy sector, with many hard assets and high fixed costs.

Industrial materials are divided into commodity producers (steel, chemicals) and producers of noncommodity value-added goods and services (machinery, some specialty chemicals).

Buyers of commodities choose their produce on price - otherwise, commodities are the same product, regardless of who makes them.

The sales and profits of companies in this sector are very sensitive to the business cycle.

Very few industrial materials companies have any competitive advantages; the exceptions are those in concentrated industries (e.g., defense), those with a specialized niche product (e.g., Alcoa, some chemicals makers), and, above all, those that can produce their goods at the lowest cost (e.g., Nucor).

Only the most efficient producers will survive the downturn:  The best bet is to be the low-cost producer and owe little debt.

Asset turnover (total asset turnover [TATO] and fixed asset turnover [FATO] measure a manufacturing firm's efficiency.

Watch out for industrial firms with too much debt, large underfunded pension plans, and big acquisitions that distract management.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



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Investor's Checklist: A Guided Tour of the Market...

Investor's Checklist: Energy

The profitability of the energy sector is highly dependent on commodity prices.  Commodity prices are cyclical, as are the sector's profits.  It's better to buy when prices are at a cyclical low than when they're high and hitting the headlines.

Even though the sector is largely cyclical, many energy companies keep their bottom lines black during the troughs.  Look for this characteristic in your energy investments.

OPEC is a highly beneficial force in the energy sector because it keeps commodity prices above its costs.  It is worth keeping tabs on the cartel's strength.

Because of OPEC, we view exploration and production as a much more attractive area than refining and marketing.

Working in a commodity market, economies of scale are just about the only way to achieve a competitive advantage.  As such, bigger is generally better because firms with greater heft tend to be more profitable.

Keep an eye on reserves and reserve growth because these are the hard assets the company will mine for future revenue.

Companies with strong balance sheets will weather cyclical lows better than those burdened with debt.  Look for companies that don't need to take on additional debt to invest in new projects while also paying dividends or repurchasing shares.


Ref:  The Five Rules for Successful Stock Investing by Pat Dorsey



Read also:
Investor's Checklist: A Guided Tour of the Market...